September 23, 2005

A Go/No Go decision

I was reading an interview (or maybe annual meeting transcript) of warren buffet sometime back and he was asked about the discount rate he uses in the DCF (discounted cash flow) calculations.

He indicated that he uses the long term treasury risk free rate. In addition, for him a decision to buy is really a go/No go decision. If he can understand the company, its economics and predict its future for 10 years or more, and if the value is screaming at him, he goes ahead. Otherwise he passes.

I have changed my decision process after reading the above comment because it makes sense for a small investor like me. If I can understand the economics of a company (which rules out a huge number as my circle of competence is small) and if the decision is a slam dunk , I go ahead and commit my money. Else I pass. Now that has resulted in my leaving a lot of companies which were close and later did very well in terms of stock price. But in the end I would rather be sure of my decision than tweak my DCF model, fiddle with my discount rate and build hypothetical assumptions of good growth and at the first downward blip , not have the confidence to hold on to the stock.

The above go/No go approach has resulted in my leaving out pharma companies, a lot of commodity companies etc. But then for a retail investor like me who needs a few good ideas a year and does not have to show a quarterly performance like a fund manager, why take the risk and the heart burn ?

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